Struggling Homeowners Confront a 'Mortgage Fiscal Cliff'

Photograph by Mark Gibson

While Congress wrangles over a debt deal, struggling homeowners may be facing a cliff of their own. That’s because a tax break aimed at helping distressed borrowers—set to expire at the end of the year—is caught up in the taxes vs. spending debate paralyzing Washington.

In the early days of the housing crisis, Congress passed the Mortgage Debt Relief Act of 2007, which waives taxes on up to $2 million in loan forgiveness. Normally, forgiven debt is taxed as income. The bill shields borrowers from taxes in three situations: when a bank modifies a mortgage to reduce the principal; when a borrower sells her home in a short sale and the purchase price is less than the outstanding balance on the mortgage; and when a bank waives the portion of the mortgage balance it couldn’t recoup in a foreclosure.

The bill was extended in 2008 and now expires on Dec. 31. In a note to clients earlier this month, Deutsche Bank’s Steven Abrahams called the expiration a “mortgage fiscal cliff” that could drag down the economy and cause more struggling homeowners to file for bankruptcy rather than work out an agreement with their lender.

On Nov. 20, 43 state attorneys general sent a letter (pdf) to Congress, asking that the tax exclusion be extended. They said they were particularly concerned that the bill’s expiration would hurt the $25 billion robo-signing settlement they negotiated with the largest mortgage servicers to help borrowers largely through short sales and principal reduction. “Failure to extend this tax exclusion will result in $1.3 billion in tax increases on the very families who can least afford it,” they said, referring to an estimate by the Congressional Budget Office.

Banks have gotten serious about loan forgiveness in recent months, in part because of the robo-signing settlement. Unless Congress acts, a key tax break will disappear just as borrowers finally have a better chance of making use of it.

    Before it's here, it's on the Bloomberg Terminal.